Navigating an uncertain recovery

After a strong restart, from here the economic path is far less clear. What could investors need to consider?

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

The global economy saw a remarkable restart in early 2021 as progress on vaccines allowed economies to reopen. This saw a rebound for many of those companies hardest hit by the lockdowns. However, since then, other factors have started to crowd the picture: inflation, supply problems, labour shortages. While the path to successful investment is never clear, today, it is particularly opaque.

It is possible to make a strong case for various – and often opposing - scenarios. Inflation may soar, fuelled by vast government spending programmes and record low interest rates. This would support stock markets, but only those companies with pricing power who can pass higher input costs onto consumers. On the other hand, deflationary forces such as technology or ageing demographics, may win, supporting high growth areas such as technology.

Equally, there remains little clarity on how markets will react to any potential tapering by the US Federal Reserve (where the central bank reduces its purchases of government bonds). The likeliest scenario now appears to be that the US central bank will begin to pare back its current quantitative easing programme by the end of the year. There is no reason that this should frighten markets, but when it has happened in the past, they have been volatile.

Among all this uncertainty sits the pandemic, which still looms. While vaccines appear to have reduced hospitalisations and deaths, many emerging markets have high unvaccinated populations and cannot reopen in full. The risk of a more infectious or vaccine-resistant variant hangs over the global recovery.

Against this backdrop, investment decision-making is tough. At the same time, the risk posed by inflation means keeping money in cash could be an expensive option. This is a time when good investment practice will be necessary. In our view, investment trusts are an important tool in building a resilient portfolio for this uncertain environment.

As we see it, investment trusts can help investors navigate an uncertain environment…

Inflationary pressure

The first challenge is inflation. It may prove transitory as central bankers predict, but this is not assured. Bottlenecks in key industries such as semiconductors, are creating supply shortages, which is pushing up prices. Wage inflation is rising as companies struggle to encourage lower-wage employees back to work. Investors need to manage the risk in their portfolios.

Investment trusts have generally done a good job of protecting investors’ income against erosion from inflation. Many investment trusts have dividend growth as an explicit part of their investment objectives and are held to this objective by their boards. Research from the AIC shows that more than four-fifths (85%) of equity income-paying investment companies increased or maintained their dividends in 2020. The equivalent figure for open-ended funds was 23%1.

Effective diversification

This is also a time when binary views are riskier. Proper diversification, across sectors, across market capitalisation and across regions is likely to be vitally important. There are certain diversifying asset classes, from frontier markets, to smaller companies, to commercial property, that may be better managed within an investment trust structure. These areas tend to be less liquid and therefore suit a closed-ended structure, where the fund manager doesn’t need to manage inflows and outflows.

In this environment, fund managers will also need to be flexible. For some time, markets have prioritised the fastest-growing companies, notably in areas such as technology. However, high prices for fast growing companies have been supported by low interest rates. In a less certain interest rate environment, it is not clear these companies will be able to sustain high valuations.

The alternative would be to move to more economically-sensitive parts of the market, such as banking or energy. These often do well at a time of rising interest rates and rising inflation. However, after a brief rally for more ‘value’ driven companies at the start of the year, enthusiasm for this type of company has waned. Again, this weakness is largely driven by uncertainty on interest rates and bond yields.

With this value/growth dynamic unclear, companies may increasingly be viewed on their own merits. This should be a market where investors are rewarded for taking the right risks at the right time, for uncovering those companies with the strongest long-term prospects, regardless of their sector. This is the bread-and-butter of investment trusts and of BlackRock investment trusts in particular. BlackRock’s managers can call on analysts across the globe to help with their decision-making and the investment trust structure allows them to back their judgement. However, there is no guarantee that a positive investment outcome will be achieved.

As we see it, investment trusts can help investors navigate an uncertain environment, offering diversification, inflation protection on capital and income, plus flexibility on investment selection. This is a moment where the advantages of investment trusts should be most in evidence.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of September 2021 and may change as subsequent conditions vary.

1Source: AIC, March 2021